Evaluating Executive Compensation

Executive compensation is a very important thing to consider when evaluating an investment opportunity. Executives who are improperly compensated may not have the incentive to perform in the best interest of shareholders, which can be costly for those shareholders. While new laws and regulations have made executive compensation much clearer in company filings, many investors remain clueless as to how to find and read these critical reports. This article will take a look at the different types of executive compensation and how investors can find and evaluate compensation information. (For related reading, see Data Mining For Investing and Lifting The Lid On CEO Compensation.)

Types of Executive CompensationThere are many different forms of executive compensation that offer a variety of tax benefits and performance incentives. Below are the most common forms:

Cash Compensation – This is the sum of all standard cash salary compensation that the executive receives for the year.

Retirement Packages – These are packages given to executives after they retire from the company. These are important to watch because they can contain so-called "golden parachutes" for corrupt executives. (For more insight, see Pages From The Bad CEO Playbook.)

Executive Perks – These are various other perks given to executives, including the use of a private jet, travel reimbursements and other rewards. These are found in the footnotes. (To learn more, check out Footnotes: Start Reading The Fine Print.)

Finding Executive CompensationAll executive compensation information can be found in public filings with the Securities and Exchange Commission (SEC). The SEC mandates that all public companies disclose how much they are paying their executives, how this amount is derived and who is involved in determining pay. The information itself is disclosed in several locations, including:

Form 8-K: The current event filing can be used to disclose compensation information if the event is related to changes in compensation policies and/or procedures.

Evaluating Executive CompensationEvaluating executive compensation can be a difficult task for the individual investor. Luckily, there are many tools that are now available to make the process much easier. These tools automatically parse SEC filings to pull the numbers and make comparisons designed to give meaning to raw information.

Pay Vs. PerformanceOne of the most popular ways to evaluate executive compensation is by comparing pay versus performance. Unfortunately, many executives are given raises and bonuses even when their companies are faltering. Comparing pay to stock performance can help you determine whether executives are overpaid. The specific metric used most often is comparing the change year-over-year in executive pay increases to the change year-over-year in stock price. Obviously, if the change in the stock price outpaces the change in pay, the executive is not overpaid. Here is an example of a comparison for Bill Gates, who was Microsoft's CEO between 1975 and 2000 and the company's chief software architect and chairman between 2000 and 2006:

Source: ExecutiveDisclosure.com

Between 1998 and 2006, Bill Gates' compensation is tied pretty closely to the company's overall performance. When the company makes more money, Gates receives more compensation and vice versa. This is healthy because it provides executives with the incentive to perform well and increase their personal wealth. Trends showing executives receiving a higher rate than performance can mean overcompensation for underperformance – which can hurt investors both in dollars paid out and incentive to perform. (For related reading, see Putting Management Under The Microscope.)

Peer ComparisonAnother popular way to evaluate executive compensation is to compare one executive to his or her industry peers. While market leaders typically have CEOs that are paid slightly more than their industries, the majority of executives should be paid on par with their peers. Here is the same example as above, except this time it's a peer comparison instead of pay vs. performance:

Source: ExecutiveDisclosure.com

Here we can clearly see that Bill Gates made more than the average executive in his industry over the charted period. Sometimes, if the executive is the founder of the company, or a high-class CEO, he or she may deserve higher compensation. Because Bill Gates is both an industry mogul and the company's founder, this may explain his comparatively higher compensation. Significant deviations between these two in standard non-founder CEOs can indicate that they are overpaid. (To learn more about how to determine whether an executive is overpaid or well paid, see Executive Compensation: How Much Is Too Much?)

Executive Compensation LawsThere have been many new laws passed to help satisfy investor concerns over executive compensation. Changes in SEC reporting requirements have forced companies to include an "Executive Compensation Discussion & Analysis" section to accompany all future pay documentation in all SEC forms. This section requires a "readable" explanation of how the compensation was determined and what it encompasses.

Other laws have been more direct in curbing practices that the companies themselves use. One prime example of this was the removal of the deferred compensation tax shelter that helped many executives avoid millions in taxes. Moreover, improvements in other tax loopholes have made it much harder for boards to justify large payouts and hide these payouts from investors.

ConclusionExecutive compensation is a very important issue for investors to consider when making decisions. An improperly compensated executive can cost shareholders money and can produce an executive who lacks the incentive to increase profits and boost share price . Meanwhile, the government is working to curb the problem with new laws that close loopholes and make the process more transparent. Combined with new analysis tools, investors are now much more informed.